Restricted Securities Regime Elections

With private equity transactions appearing to be on the increase, perhaps now is a good time to revisit what employers and employees need to consider when deciding whether or not to make a restricted securities regime election.

The underlying principle of the restricted securities regime is that if an employee acquires restricted securities (e.g. shares which are subject to transfer restrictions), income tax on the proportion of the unrestricted market value ("UMV") (i.e. the market value of the restricted securities ignoring the effects of the restrictions) which represents the difference between the actual market value of the securities, taking account of the restrictions ("AMV") and the UMV of the securities, is deferred. When a restriction is lifted or the securities are sold (a chargeable event), the proportion of the unrestricted market value which is released is then charged to income tax.

Without such a regime, when restrictions are lifted (and as such increasing the value of the employee's holding), the rise in value would not be taxed and any gain arising when the restricted securities are sold would only be taxed under the capital gains tax regime (which tends to be much more favourable to a tax payer than the income tax regime).

Restricted Securities

The restricted securities regime is contained in Chapter 2 of Part 7 of the Income Tax (Earnings and Pensions) Act 2003 ("ITEPA"). It applies to "securities" or "interests in securities" which are both "employment related securities" and "restricted securities" or "restricted interests in securities".

The above terms are defined in the legislation. Although the scope of this article does not extend to considering their meaning in detail, as Chapter 7 has been drafted with a pronounced anti-avoidance motive, it will be of no surprise that each term is given a wide meaning. In the context of private equity transactions, shares acquired by a manager, for example in a company incorporated to acquire a target, will be restricted securities if the shares are subject to "good/bad leaver" provisions and such provisions reduce the market value of the shares.

As mentioned above, the restricted securities regime is broadly designed to impose an income tax charge on any untaxed value of restricted securities owned by an employee when the restrictions on the securities are lifted or the restricted securities are sold.

It should be noted that where an income tax charge arises on the lifting of a restriction, the employee will have to find the money to pay the tax bill. The same is true if an income tax charge arises on making a restricted securities regime election at the time of acquisition (see below).

On the occurrence of a chargeable event, the taxable amount is calculated in accordance with the following formula:

(UMV x (IUP – PCP – OP)) - CE

where:

UMV is the unrestricted market value of the securities immediately after the chargeable event (i.e. their market value ignoring the effects of the restrictions).

IUP is the "initial uncharged proportion" and its value is calculated by using the formula:

(IUMV – DA) / IUMV

In this formula:

IUMV...